Behind The Demand Curve I 1.Marginal utility theory assumptions assumptions law of diminishing...
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Behind The Demand Curve I Behind The Demand Curve I 1.Marginal utility theory 1.Marginal utility theory assumptions assumptions law of diminishing marginal law of diminishing marginal utility utility optimal consumption optimal consumption critique critique 2. Uses of utility theory? 2. Uses of utility theory?
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Transcript of Behind The Demand Curve I 1.Marginal utility theory assumptions assumptions law of diminishing...
Behind The Demand Curve IBehind The Demand Curve I
1.Marginal utility theory1.Marginal utility theory assumptionsassumptions law of diminishing marginal utilitylaw of diminishing marginal utility optimal consumptionoptimal consumption critiquecritique
2. Uses of utility theory?2. Uses of utility theory?
UsesUses
(i) Elasticity - determined by preferences. (i) Elasticity - determined by preferences. How quickly MU diminishesHow quickly MU diminishes
(ii) Efficiency - consumer surplus. (ii) Efficiency - consumer surplus. Resource allocationResource allocation
(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water
AssumptionsAssumptions
Consumers are rationalConsumers are rational
Ceteris paribusCeteris paribus
Cardinalist approach - utilsCardinalist approach - utils
Utility = satisfaction (preferences)Utility = satisfaction (preferences)
Measurement of utilityMeasurement of utility
Total utilityTotal utility “… “… the total satisfaction gained from the the total satisfaction gained from the
consumption of ALL units of a commodity.”consumption of ALL units of a commodity.”
Marginal utilityMarginal utility “…“…the the extraextra utility derived from the utility derived from the
consumption consumption of of one moreone more unit of a good, the unit of a good, the consumption of all other goods remaining consumption of all other goods remaining unchanged.”unchanged.”
See Figure 1-3 - shape & calculationSee Figure 1-3 - shape & calculation
figfig
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Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)
No. of creamcakes
TUin utils
0123456
07
1113141413
Util
ity (
util
s)
No. of cream cakes consumed (per day)
figfig
-2
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0 1 2 3 4 5 6
Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)
No. of creamcakes
TUin utils
0123456
07
1113141413
Util
ity (
util
s)
No. of cream cakes consumed (per day)
TU
figfig
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0 1 2 3 4 5 6
No. of creamcakes
TUin utils
0123456
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1113141413
MUin utils
-74210
-1
Util
ity (
util
s)
No. of cream cakes consumed (per day)
TU
Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)
figfig
-2
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0 1 2 3 4 5 6MU
MU = TU / Q = 2/1 = 2
Util
ity (
util
s)
No. of cream cakes consumed (per day)
TU
Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)
TU = 2
Q = 1
The Law of Diminishing Marginal UtilityThe Law of Diminishing Marginal Utility
Slope of the MU scheduleSlope of the MU schedule
DefinitionDefinition “…“…as the quantity of a good consumed by an as the quantity of a good consumed by an
individual increases, the marginal utility of the individual increases, the marginal utility of the good will eventually decrease.”good will eventually decrease.”
Marginal analysisMarginal analysis
Optimal consumption - backgroundOptimal consumption - background
Consumers have limited income. Choices. Consumers have limited income. Choices. No savingNo saving
Rational consumer - maximise utility Rational consumer - maximise utility
Measurement problem - utils?Measurement problem - utils?
Solution: measure utility in moneySolution: measure utility in money price prepared to payprice prepared to pay
price you actually payprice you actually pay
Optimal consumption - single goodOptimal consumption - single good
Buy one extra unit whenBuy one extra unit when
MU > PriceMU > PriceMU (in monetary terms) = marginal benefitMU (in monetary terms) = marginal benefit
Price = marginal costPrice = marginal cost
Stop when Stop when MU = PriceMU = Price
Optimal consumption - consumer Optimal consumption - consumer surplus(CS)surplus(CS)
Consumer surplusConsumer surplus Price prepared to pay - price actually paidPrice prepared to pay - price actually paid
Marginal consumer surplusMarginal consumer surplus MCS = MU - marginal expenditureMCS = MU - marginal expenditure MCS = MU - PMCS = MU - P
i.e. the excess of utility over pricei.e. the excess of utility over price
Buy more when MU > P (MCS positive). Buy more when MU > P (MCS positive). Stop MU = PStop MU = P
Derivation of the demand curveDerivation of the demand curve
Equals the MU curve as long as Equals the MU curve as long as consumers maximise CSconsumers maximise CS
If price falls: buy more since MU > P or If price falls: buy more since MU > P or MCS is positiveMCS is positive movement along demand schedulemovement along demand schedule
figfig
ConsumerConsumersurplussurplus
40
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0 250 500 750 1000
Marginal utility from petrolMarginal utility from petrol
a
b
c
MU
, P (
pen
ce p
er li
tre
)
Q (litres per annum)
MUMU
Optimal consumption - multi-good caseOptimal consumption - multi-good case
Equi-marginal principleEqui-marginal principle MUMUaa \ P \ Paa = MU = MUbb \ P \ Pbb = MU = MUcc \ P \ Pcc = … MU = … MUnn \ P \ Pnn If price of a good changes - reallocate incomeIf price of a good changes - reallocate income
If income is fixedIf income is fixed ……utility is maximised when the utility from the utility is maximised when the utility from the
LAST pound spent on ALL goods is equalLAST pound spent on ALL goods is equal
UsesUses
(i) Elasticity - determined by preferences. (i) Elasticity - determined by preferences. How quickly MU diminishesHow quickly MU diminishes
(ii) Efficiency - consumer surplus. (ii) Efficiency - consumer surplus. Resource allocationResource allocation
(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water
